Avoid Position Sizing Pitfalls in Short- and Long-Term Trades

Why you adjust your lot sizes to the timing of your trade

There are all kinds of different traders out there, but it’s common to classify them into two categories: long-term versus short-term. A lot of traders are biased to the short term because it’s cheaper with a lower cost structure. Since the price you pay is one of the few things you have 100% control over, that should be maximized.

However, when it comes to short- versus long-term strategies, the biggest mistake people make is trying to apply the principles of a long-term trade onto a short-term trade, or even worse—vice versa. I have a good example I’d like to share to explain exactly what this mistake is, and why I think traders are persisting in it.

2 Forex Setups

We’re going to look at the British pound (GBP) and the yen (JPY). I’m going to look at two opportunities. One is a technical opportunity on a long-term basis, it’s a breakout from consolidation to the downside, a rising wedge that occurred in 2008. And the other is a breakdown from a triple top that occurred on a very short-term basis.

These technical formations are independent of time frame. A triple top on the daily charts is just as interesting to most traders as a triple top on a five-hour chart or a four-hour chart. Since technical analysis is somewhat time-frame independent, traders get confused about one very important factor that is not independent of time frame—position sizing.

I’m going to detail the components of these two trades, then we’re going to contrast what it should look like from a stop-loss and position sizing perspective.

Both case study trades were short (bearish) and utilized technical analysis. In both it was assumed that a stop was set above resistance to protect capital.

The first trade was a rising wedge that occurred over March of 2008 to August of 2008.

Case Study #1: Long Term

Click to Enlarge As you can see in the chart, the GBP/JPY began consolidating in a rising wedge pattern from March 2008 through August of 2008. When the breakout occurred in August an initial profit target, based on the prior trend, provided a projected upside potential of about 5,500 pips.

Based on the profit target and upside resistance levels a stop loss could have reasonably been placed almost 1,000 pips above the breakout, near resistance, to protect capital.

The large stop in this case was perfectly reasonable to account for volatility that may occur in the near term as the trend began to reemerge. If you assume that you had a $10,000 account balance and were willing to risk 5% on any given trade, you would round up and only be trading 1 mini lot in this case.

Case Study #2: Short Term

Click to Enlarge In this chart, the GBP/JPY had formed a triple top and subsequently broke down to an initial profit target of 335 pips. A stop above resistance could have been placed at least 100 pips away. Assuming the same kind of portfolio sizing calculation was done in this trade as in the last one, you could have been trading 5 lots.

As you can see in these two contrasting examples, the analysis was similar but the position sizing was proportional. Traders applying a 100 pip stop loss in the long term position would have accumulated large losses as the market remained volatile and “whipped” them out. Similarly, an extremely large stop loss would have essentially left the short term position uncovered.

The issue is compounded by the fact that a longer term trader applying a short term stop loss may have been getting in too heavily. We have found that it is very common for traders taking advantage of a long term trade to get spooked very early because they are in the trade with too much size.

Trading in the short term can be fun but it is expensive. The forex is one of the most expensive markets to trade in the short term and in this example the costs associated with the short term trade could easily have been 1.5% of profits. In the long term example, costs were 0.0009% of profits. That makes a huge difference over many trades and could ultimately make the difference between an annual profit or loss.

If any of this sounds familiar to you, take a minute to reevaluate how you are position sizing and make sure that your initial targets and stop losses are proportional to the opportunity rather than transposed from another time frame.

InvestorPlace advisors John Jagerson and S. Wade Hansen are co-founders of LearningMarkets.com, as well as the co-editors of SlingShot Trader, a trading service designed to help you make options profits by trading the news. Get in on the next trade and get 1 free month today by clicking here.

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